3/04/2002 @ 12:00AM

More Ploys

Adding pension gains and ignoring stock-option pay are common ways to inflate earnings. Here are the real performances.

If cooked-up profit figures have been drawing the attention of congressional committees, it’s high time they became a worry for investors. The preceding story (p. 102) talks about some exotic maneuvers, such as gain-on-sale accounting. Now let’s look at two profit-puffers that are extremely common: the inclusion of pension gains and the exclusion of option-related compensation costs.

First the pensions. If a company has an overflowing balance in its defined benefit plan–the old-fashioned kind, mainly found at big industrial corporations with unions, not the 401(k) do-it-yourself type–then net income gets a boost. The company can put itself down for a small pension cost, or even a negative figure. Some fluctuations in pension costs are an inevitable consequence of actuarial arithmetic, but note that a pension sponsor has a certain amount of flexibility in making the assumptions that go into actuarial calculations. By changing assumptions, it can artificially depress the pension cost.

One of those assumptions is about the average investment return the pension portfolio will enjoy over the next several decades. The higher the assumed future return, the less the plan needs in the bank now to fund future payouts. An actuarially overfunded plan can give rise to a credit–a negative cost–on the profit-and-loss statement. This is not, generally speaking, money the company can use to pay dividends; it’s just a paper entry. It is nothing like a profit contribution that comes from selling more widgets or making them more efficiently.

Example, oversimplified: A company with $1 billion in pension assets has to pay out $80 million a year to retirees. Plan managers, though, figure they can earn 10% over time, or a hypothetical $100 million a year on the assets. The hoped-for $20 million difference gets credited to pretax income, notwithstanding that the portfolio might have earned less last year or even lost money.

The second matter of controversy has to do with the use of stock options to attract employees. Bowing to pressure from high-tech companies that hand out employee options liberally, the accounting authorities permit the value of options to be omitted from compensation costs.

The rationale for this treatment is that option awards are not a cash expense and that the potential dilution if the options are exercised is duly noted in diluted earnings-per-share figures. Jack T. Ciesielski, a corporate accounting expert who publishes the Analyst’s Accounting Observer out of Baltimore, Md., doesn’t buy this argument. Options have a value, he says; they replace what would otherwise have been cash salaries; and to get a fair view of how profitable a business is you should expense option costs, along with cash compensation, on the income statement.

Ciesielski has calculated the effect of these two profit boosters, relating to pensions and options, on cumulative earnings for the companies in the S&P 100 index over the period 1996 through 2000. The table below shows the ten with the biggest lift from these ploys. Reported earnings for the S&P 100 came to a total of $970 billion over the five years, with pension gains accounting for $39 billion of that sum and the omission of stock option costs accounting for $49 billion.

On a sector-by-sector basis, companies in the materials industry were the worst offenders, averaging a 22% difference over the five years between their Ciesielski-adjusted earnings and what they reported. International Paper was especially egregious: It booked a five-year total of $1.04 billion in earnings but would have reported only $409 million by using Ciesielski’s method. Stock options are, no surprise, a big item in the information technology sector, where $25 billion of related earnings boosts took place.

Viacom takes top prize for having the biggest swing between what its profit total should have been and what it reported (487%), with Lucent and AOL Time Warner (the pre-merger AOL is reflected here) following close behind. Among the top ten worst offenders, the adjusted net income would have left each still profitable, albeit less so, with the exception of Unisys. The ever-struggling computer outfit lost $18.9 million over the five years; its real red ink was $528 million by Ciesielski’s reckoning.

As you might expect, the companies mostly defend their pension and options accounting. International Paper disagrees with Ciesielski’s calculations. AOL says the analysis effectively overstated the impact of these items. Toolmaker Black & Decker knocks Ciesielski’s method for not taking into account a large goodwill writeoff it took in 1998–a noncash acquisitions-related charge that, it argues, artificially lowered net income and made the effect of the options treatment a bigger share of reported profit. Allegheny Technologies says it and its overfunded plan are so well run that the pension credit turned into not just a paper gain but real cash for the company’s benefit, since this overfunding was used to pay retiree medical costs and thus reduce cash benefit costs.

The big hazard in the pension and option profit boosters: They don’t work in bear markets, like the one we’ve been in. Assumptions about future pension returns may have to be lowered. Employees may spurn options and look for cash pay.

General Electric (not on our top 10–it’s number 35) is a case in point, says money manager Robert Olstein. In the past the pension fund was lovely manna for GE: Olstein says 9%, or $1.7 billion, of the company’s $18 billion pretax income in 2000 came from there. Well, the party’s is almost over. GE’s gains from its employee pension fund for 2002 will decline to between $850 million and $1.2 billion, Olstein estimates. The drop ought to knock a nickel to 7 cents off 2002 share earnings, which Value Line forecasts at $1.55.

Figures are cumulative for 1996 through 2000. (1)Figures do not include Time Warner. Sources: The Analyst’s Accounting Observer; company filings.